Chapter 3

Supply & Market

Equilibrium
 Supply

Quantity supplied is the amount of a

good that sellers are willing and able
to sell.
 Law of Supply

The law of supply states that there is a

direct (positive) relationship between price
and quantity supplied.

P S
 Determinants of Supply

 Market price
 Input prices
 Technology
 Expectations
 Number of producers
 Supply Schedule

The supply schedule is a table that

shows the relationship between the
price of the good and the quantity
supplied.
Supply Schedule

Price Quantity
$0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5
 Supply Curve

The supply curve is the upward-

sloping line relating price to quantity
supplied.
Price of Supply Curve
Ice-Cream
Cone
$3.00 Price Quantity
$0.00 0
2.50
0.50 0
2.00 1.00 1
1.50 2
1.50 2.00 3
2.50 4
1.00
3.00 5
0.50

Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 Ice-Cream
Cones
 Market Supply

 Market supply refers to the sum

of all individual supplies for all
sellers of a particular good or
service.
Determinants of Supply

 Market price
 Input prices
 Technology
 Expectations
 Number of producers
 Change in Quantity Supplied
versus Change in Supply

Change in Quantity Supplied

 Movement along the supply curve.
 Caused by a change in the market price
of the product.
 Change in Quantity Supplied
Price of
Ice-Cream
Cone
S
C
$3.00 A rise in the price
of ice cream cones
results in a
movement along
the supply curve.
A
1.00

Quantity of
0 1 5 Ice-Cream
Cones
Change in Quantity Supplied
versus Change in Supply

Change in Supply
 A shift in the supply curve, either to the
left or right.
 Caused by a change in a determinant
other than price.
 Change in Supply
Price of S3
Ice-Cream
Cone
S1 S2
Decrease in
Supply

Increase in
Supply

Quantity of
0 Ice-Cream
Cones
 Change in Quantity Supplied
versus Change in Supply
Variables that
Affect Quantity Supplied A Change in This Variable . . .
Price Represents a movement along
the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
 Supply and Demand Together
Equilibrium Price
 The price that balances supply and
demand. On a graph, it is the price at which
the supply and demand curves intersect.
Equilibrium Quantity
 The quantity that balances supply and
demand. On a graph it is the quantity at
which the supply and demand curves
intersect. 
Supply and Demand Together
Demand Schedule Supply Schedule

Price Quantity Price Quantity

$0.00 19 $0.00 0
0.50 16 0.50 0
1.00 13 1.00 1
1.50 10 1.50 4
2.00 7 2.00 7
2.50 4 2.50 10
3.00 1 3.00 13

At $2.00, the quantity demanded is

equal to the quantity supplied!
 Equilibrium of
Price of Supply and Demand
Ice-Cream
Cone
Supply
$3.00

2.50 Equilibrium

2.00

1.50

1.00

0.50 Demand
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 Ice-Cream
Cones
Graphical Review
Of
Equilibrium
 How an Increase in Demand
Affects
Price of
the Equilibrium
Ice-Cream
Cone

Supply

2.00
Initial
equilibrium

D1
0 7 10 Quantity of
Ice-Cream Cones
 How an Increase in Demand
Affects the Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

2.00
Initial
equilibrium

D1
0 7 10 Quantity of
Ice-Cream Cones
 How an Increase in Demand
Affects the Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

$2.50 New equilibrium

2.00
Initial
equilibrium
D2

D1
0 7 10 Quantity of
Ice-Cream Cones
 How an Increase in Demand
Affects the Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

$2.50 New equilibrium

2.00
2. ...resulting Initial
in a higher equilibrium
price...
D2

D1
0 7 10 Quantity of
Ice-Cream Cones
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

How an Increase in Demand

Affects the Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

$2.50 New equilibrium

2.00
2. ...resulting Initial
in a higher equilibrium
price...
D2

D1
0 7 10 Quantity of
3. ...and a higher Ice-Cream Cones
quantity sold.
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

How an Increase in Demand

Affects the Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

$2.50 New equilibrium

2.00
2. ...resulting Initial
in a higher equilibrium
price...
D2

D1
0 7 10 Quantity of
3. ...and a higher Ice-Cream Cones
quantity sold.
 How a Decrease in Supply Affects
the Equilibrium
Price of
Ice-Cream
Cone

S1

2.00 Initial equilibrium

Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
 How a Decrease in Supply Affects
the Equilibrium
Price of
Ice-Cream 1. An earthquake reduces
Cone the supply of ice cream...

S1

2.00 Initial equilibrium

Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
 How a Decrease in Supply Affects
the Equilibrium
Price of
Ice-Cream 1. An earthquake reduces
Cone the supply of ice cream...

S1

2.00 Initial equilibrium

Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
 How a Decrease in Supply Affects
the Equilibrium
Price of
Ice-Cream 1. An earthquake reduces
Cone the supply of ice cream...

S1

New
$2.50 equilibrium

2.00 Initial equilibrium

Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
 How a Decrease in Supply Affects
the Equilibrium
Price of
Ice-Cream 1. Shortage of milk reduces
Cone the supply of ice cream...

S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. ...resulting
in a higher
price...
Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
 How a Decrease in Supply Affects
the Equilibrium
Price of
Ice-Cream 1.Shortage of milk reduces
Cone the supply of ice cream...

S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. ...resulting
in a higher
price...
Demand

0 1 2 3 4 7 8 9 10 11 12 13 Quantity of
3. ...and a lower Ice-Cream Cones
quantity sold.
 Elasticity of Supply
The elasticity of supply establishes a quantitative
relationship between the supply of a commodity and it’s
price.

Es= [(Δq/q)×100] ÷ [(Δp/p)×100] = (Δq/q) ÷ (Δp/p)

Δq= The change in quantity supplied
q= The quantity supplied
Δp= The change in price
p= The price
Types of Elasticity of Supply

?
 Production Analysis
Production is transformation activity that connects factor
inputs and outputs.

The process of transformation of inputs to outputs can

be transformed in any of following three ways:
1} Change in form: E.g. transformation of raw
materials into finished goods.
2} Change in place: E.g. transportation
3} Change in Time: E.g. storage
Factors of Production

1- Land
2- Labor
3- Capital
4- Enterprises
PRODUCTION FUNCTION
 Definition:It refers to the functional relationship
under the given technology, between physical rates
of input and output of a firm, per unit of time.
 Q= f(a,b,c,d…,n,T)
 Flow concept
 Physical concept
 State of technology & Inputs
 Some inputs are substitutes to one another
 Some inputs many be specific
 Factors’ combination for maximum output
 Short run & Long run production function
LAW OF VARIABLE
PROPORTIONS

 Modern version of Law of Diminishing

Marginal Returns- Alfred Marshall -An
increase in capital and labour applied in
the cultivation of land causes in general a
less than proportionate increase in the
amount of produce raised, unless it
happens to coincide with an
improvement in the art of agriculture.
LAW OF VARIABLE
PROPORTIONS

ASSUMPTIONS
1. Only one factor is varied and all other factors
should remain constant.
2. The scale of output is unchanged and the
production plant or the size efficiency of the
firm remain constant.
3. The technique of production does not change
4. All units of the factor input varied are
homogenous.
 Concepts
1. Total Product-Total number of units of output
produced per unit of time by all factor inputs
is referred to as total product. In the short
run, TP= f(QVF)
2. Average Product- AP refers to the total
product per unit of a given variable factor.
AP= TP/QVF
3. Marginal Product-Owing to the addition of a
unit to a variable factor, all other factors being
held constant, the addition realised in the total
product is referred to as MP.
MPn= TPn- TPn-1
Explanation of the Law
Stage I Stage II Stage III

TP increases at TP increases at TP starts

increasing rate decreasing rate decreasing
AP increasing Max AP= MP AP decreasing
MP increasing MP increasing MP= Negative

•When AP is maximum, AP=MP

•When TP is Max, MP becomes zero
 Increasing Returns- Indivisibility of fixed factors
& internal economies –managerial, technical
 Diminishing Returns- Imperfect substitutability
of factors- overutilisation of fixed factors&
internal diseconomies
 Negative Return- Excess use of variable factor-
reducing the productivity

Two Fundamental characteristics of factors of

production-
•Indivisibility of certain fixed factors
•Imperfect substitutability between factors
 Costs

Cost concept means that the amount where any asset is

bought is to be written in the financial statement. The
marked price is not to be written here but exact the amount
in which the asset is bought should be written.
Opportunity Cost
 A benefit, profit, or value of something
that must be given up to acquire or
achieve something else. Since every
resource (land, money, time, etc.) can be
put to alternative uses, every action,
choice, or decision has an associated
opportunity cost.
Opportunity costs are fundamental costs in economics,
and are used in computing cost benefit analysis of a
project. Such costs, however, are not recorded in the
account books but are recognized in decision making by
computing the cash outlays and their resulting profit or
loss.
 Private & Social Cost
 Private cost refers to the cost of production incurred and provided
for by an individual firm engaged in the production of a
commodity. It is found out to get private profits. This cost has
nothing to do with the society. It includes both explicit as well as
implicit cost. A firm is interested in minimizing private cost.

 Social cost refers to the cost of producing a commodity to the

society as a whole. It takes into consideration all those costs,
which are borne by the society directly or indirectly. Social cost is
not borne by the firm. It is rather passed on to persons not
involved in the activity in the direct way. Social cost is a much
broader concept.
 Accounting Cost
 Accounting costs are the explicit costs, also known hard
costs that are seen as money out of your bank account that
you need to run your business. These are production costs,
lease payments, marketing budgets and payroll. In other
words, these are the real costs in manufacturing, marketing
and delivering your products.
 Explicit costs have a monetary value and are easily
identified on a bookkeeper's ledger. Accounting costs are
generally real-time costs that are deducted from revenues in
any given accounting period.
 Economic Cost

 Economic costs include the same explicit costs that

accounting costs use in calculations, but economic
costs also include implicit costs. Implicit costs are
those values that are not listed on the ledger, and they
are assumed by the business to utilize resources. The
idea with implicit costs is that the business could
make more by using an asset in a different, more
traditional fashion.
Short Run & Long Run Cost

 The main difference between long run and

short run costs is that there are no fixed
factors in the long run; there are both fixed
and variable factors in the short run. In the
long run the general price level, contractual
wages, and expectations adjust fully to the
state of the economy.
Economies of Scale
 The advantages of large scale production
that result in lower unit (average) costs
(cost per unit)
 AC = TC / Q
 Economies of Scale – spreads total costs
over a greater range of output.
Economies of Scale
Internal Economies of Scale advantages
that arise as a result of the growth of the firm
by lowering long run average cost..

 Technical
 Commercial
 Financial
 Managerial
 Risk Bearing
Economies of Scale

External Economies of Scale – the advantages

firms can gain as a result of the growth of the
industry – normally associated with a particular area
by lowering long run average cost..

 Supply of skilled labour

 Local knowledge and Skills
 Infrastructure
 Training facilities
 Cost Function
 A cost function is a function of input prices and output
quantity whose value is the cost of making that output
given those input prices, often applied through the use
of the cost curve by companies to minimize cost and
maximize production efficiency.

 In economics, the cost function is primarily used by

businesses to determine which investments to make
with capital used in the short and long term. 
Short-run costs

Total cost
 Total costs for firm
100
Output TFC
(Q) (Rs.)
TVC TC
X
(Rs.) (Rs.)
TC
0 12 0 12
1 12 10 22
TV
80 2 12 16 28 C
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
0 1 2 3 4 5 6 7 8
 Total costs for firm
100
X TC
TV
80
C
Diminishing marginal
60 returns set in here

40

20

TFC
0
0 1 2 3 4 5 6 7 8
Short-run costs

Marginal cost = TC / Q
Costs (Rs.) Deriving marginal costs
120

Q TC MC
100
0 12 10 TC
1 22 6
80
2 28 5
60
3 33 7
4 40 12
40 5 52 20 Diminishing
6 72 31 returns set MC
in here
20 7 103
0
0 1 2 3 4 5 6 7
Q
Short-run costs

Average cost
=TC / Q
Costs (Rs.)
35
Q TC AC
0 12
30 1 22 22
25
2 28 14
3 33 11
20 4 40 10
15
5 52 10.4 AC
6 72 12
10 7 103 14.7 AVC
5
AFC
0
0 1 2 3 4 5 6 7
Q
Costs (Rs.) Q TC MC AC
35 0 12 10 - MC
30
1 22 6 22
2 28 5 14
25 3 33 7 11
20
4 40 12 10
5 52 20 10.4
15 6 72 31 12 AC
10
7 103 14.7

0
0 1 2 3 4 5 6 7
Q
Average and marginal costs
MC
AC

AVC
Costs (Rs.)

x
AFC

Output (Q)
Long-run costs

Long-run costs
=TC / Q
Alternative long-run average cost
curves

Economies of Scale
Costs

LRAC

O Output
Alternative long-run average cost
curves

LRAC
Diseconomies of Scale
Costs

O Output
Alternative long-run average cost
curves

Constant costs
Costs

LRAC

O Output
A typical long-run average cost
curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
Long-run costs

Relationship between
short-run and long-run
AC curves
Deriving long-run average cost curves: factories of fixed size

SRAC1 SRAC SRAC5

2
SRAC4
SRAC3

5 factories
Costs

1 factory
2 factories
3 factories4 factories

O
Output
Deriving long-run average cost curves: factories of fixed size

SRAC1 SRAC SRAC5

2
SRAC4
SRAC3

LRAC
Costs

O
Output
Deriving long-run average cost curves: choice of factory size
Costs

Examples of short-run
average cost curves

O
Output
Deriving long-run average cost curves: choice of factory size

LRAC
Costs

O
Output
Any ?